What is a REIT? A guide to real estate investment trusts

Maybe you like the idea of investing in real estate, but you don’t want to own your own home and deal with upkeep. Perhaps you want to generate passive income from real estate, but you don’t want to become a landlord. Maybe it’s just about diversifying your investment portfolio. Whatever the reason, a REIT may be a good option. But what is a REIT?

What is a REIT?

A real estate investment trust (REIT) is an entity that has ownership and operates and/or finances income-producing properties in various sectors of the real estate market. To qualify as a REIT, the Internal Revenue Code specifies some strict guidelines:

• It has to be managed by one or more trustees and have transferable shares of interest or the equivalent with at least 100 investors.
• At least 95% of its income has to come from dividends, interest or revenue derived from real estate operations.
• Moreover, 75% of income has to come from real estate investment activities directly.
• 75% of the total asset value has to be in real estate, cash or U.S. government securities.
• Five or fewer individual investors cannot own more than half the interest in the REIT in the back half of the year.

What properties do REITs invest in?

REITs have a variety of different focuses: here are a few of the biggest examples:

• Residential REITs: Residential REITs focus on investing in spaces that people can use as their personal residence. These include everything from single-family homes to townhomes, condos and apartments. The properties may also serve as vacation homes or student housing.
• Commercial REITs: Commercial REITs invest in spaces used by business like offices, parking lots, shopping and strip malls, hotels and warehouses.
• Health care REITs: Health care REITs are like a specialized form of commercial REIT dedicated to the medical sector. They invest in properties like hospitals, nursing homes, senior and assisted living facilities, and clinics.

How do REITs work?

REITs take many forms, including publicly traded, nonpublicly traded and private ownership groups. Publicly traded REITs are offered on stock exchanges. Nonpublic REITs are traded over the counter, but they’re still registered securities. There are some that are private REITs, exempt from standard securities law. These can only be sold to qualified institutional buyers.

The REITs are under the management of one more trustees. They may have directors that decide the direction of the fund and the types of properties in which it invests. Executive management may be employed to identify properties to invest in and supervise their management. External advisors may be consulted from time to time to provide oversight.

REITs make their money from the interest underlying mortgages associated with the properties or the collection of rent, if someone is a tenant rather than owning the home.

Types of real estate investment trusts

When it comes to REITs, there are three major types and one crossover category for investments that don’t fit neatly anywhere else.

Equity REITs

Equity REITs have ownership in and/or manage all kinds of income-producing properties. They make their revenue from the rent collected from tenants, whether it’s a residential apartment complex or commercial space. They distribute the vast majority of the profit to investors as dividends after taking out operating expenses.

Mortgage REITs

Mortgage REITs (mREITs) involve getting income from the interest underlying mortgages held by the REIT and then paid by those living in the properties. The REIT may originate the loan or they may have purchased the underlying mortgage-backed security.

Residential mortgage REITs are considered safer than commercial ones because people are more likely to make the mortgage payment where they live than on a business investment. However, commercial investors are compensated with higher rates.

Hybrid REITs

Hybrid REITs are a mix of equity REITs and mREITs. This means revenues are based on both collective rents and mortgage interest paid back. The idea here is to diversify and limit exposure to any one particular sector of real estate in the event of an economic turn.

Specialty REITs

Specialty REITs are those that don’t fit neatly into the definition of any other category. The best way to think about this is that it’s anything where the revenue drivers aren’t rent or mortgage interest.

Examples of this would be REITs owning amusement parks, movie theaters or billboards. REITs may even own farms.

Pros of REIT investing

There are several benefits to investing in REITs:

• Liquidity: if you want to cash out your investment, it’s easier to sell shares in a REIT than it is to sell real estate. If it’s publicly traded, you could have this done in minutes as opposed to weeks or months.
• Investment diversification: If you’re investing in other markets like stocks or bonds, this could give you a way to devote part of your portfolio to real estate without having to buy houses.
• Dividend income: We’ll get into the exact details later on, but because REITs have to pay out the vast majority of their profits in dividends in order to retain their tax-advantaged status, this could be a good passive income stream.

Cons of REIT investing

While there are benefits, there are also downsides to investing in REITs.

• Market risk: By investing in real estate in any form, you’re exposing yourself to the ups and downs of the real estate market. If property values fall or more people are foreclosing due to an economic downturn, there’s the chance the investment goes south.
• Interest rate sensitivity: People’s interest in real estate and their ability to make their payments tends to rise and fall depending on what’s happening with interest rates. There’s less exposure if the interest rates are fixed.
• Management fees: REITs have to be managed by trustees and there are also directors of the funds. The management fees may eat into the profit you see.

How to invest in REITs

If you’re looking to invest in REITs, there are several steps you should follow to make sure you’re in the right investment for you.

1. Understand the different types of REITs

It’s important to get your head around the different types of REITs before investing so you truly understand the type of risk you may be exposing yourself to. For example, equity REITs tend to be funded by rents from apartments and businesses.

Meanwhile, residential mortgage REITs are based on mortgage payments and the interest they provide. Specialty REITs make most of their money off something other than rent or mortgage interest.

2. Determine your investment goals

Your investment goals are a big part of determining whether a REIT fits into your investment portfolio. If you want high rates of return with more risk, stocks might be better. At the same time, REITs aren’t as safe as bonds because there is the potential for dealing with a downturn in the housing or commercial real estate market. REITs are somewhere in the middle.

3. Research potential REIT investments

You should research your investments if you go this route. You can do things like compare REITs by rate of return, historical performance and management fees. Be sure to read the prospectuses at least well enough to understand what you’re getting into.

4. Choose how you want to invest in REITs

You need to know whether you want to get into a publicly traded REIT or one that’s nonpublicly traded. If you want to get into a private REIT, you’ll need a relationship with an institutional investor. If you go this direction, be extra sure that this is what you want because the reporting requirements on private REITs aren’t going to be as stringent as public ones.

If you want to invest in public REITs yourself, you’ll need a personal brokerage account and a funding source. There are both traditional brokers and those who specialize in online operations.

5. Monitor and manage your REIT investments

Once you’ve invested, it’s important to monitor the performance of your investments. You don’t have to look every day, but you should periodically re-evaluate whether the REIT investment is still accomplishing what you want it to.

Think of it not in isolation, but in terms of your overall portfolio. Should you focus your investments in one area more than another based on market swings or life changes?

Tax implications of REIT real estate investing

One of the cool things about REITs is that they aren’t taxed on income as long as they give 90% of their revenue back to investors after expenses, which incentivizes giving the money back to investors.

Individual investors are taxed on the payouts. These are called dividends. Most dividends for things like mortgage interest payments or collected rent are taxed as ordinary income so it would be based on whatever your usual tax bracket is.

One of the exceptions to this is if property is sold in the REIT. That would be subject to capital gains tax at a maximum rate of 20%. The other factor is that there is an additional 3.8% tax on net investment income if you fall above certain modified adjusted gross income (MAGI) levels:

If REIT investments are part of your retirement accounts, it should be noted that investment returns aren’t taxed while they’re in your account. Instead, if you have a traditional 401(k) or IRA, you pay tax at ordinary income rates when you withdraw. Roth 401(k)s or IRAs aren’t taxed on withdrawal because the taxes are paid when the money goes in.

If you have questions regarding your individual tax situation, we recommend speaking to an accountant or other tax professional.

The bottom line

REITs allow you to invest in real estate without having to actually buy a house or deal with responsibilities of being a landlord or hiring a property management firm. REIT shares are traded publicly on exchanges or over the counter or privately through investment firms. Mostly, their money is made through collecting rent or mortgage interest, but there are other models.

Before investing in REITs, consider how they fit in with your other investment goals and the rest of your portfolio. Do your research on individual trusts to identify the right opportunity and monitor how things are going from time to time. Consult a financial advisor if you feel the need. You can also look into other types of real estate investments.